When you’re new to the workforce, the last thing on your mind is probably retirement planning. But actually, this should be at the top of your to-do list, and it’s an easy A. There’s no need to overthink it and a few simple steps are all you need to get started.
If you work for an employer offering a retirement plan (such as a 401(k) or 403(b)) with an auto-enrollment option, you’re off to a solid start. But regardless of what your plan offers, read on for a few simple steps you can take to get an A on your 401(k):
Pick a target-date fund
According to recent Vanguard research, 99% of all plans with auto-enrollment put participants into a balanced investment strategy, with 97% of those plans choosing a target-date fund as the default.
These investments typically offer low costs, a globally diversified asset allocation, and rebalancing—all in one fund. If you’re selecting your own retirement plan options, consider a target-date fund with the year in which you roughly estimate you’ll retire (typically, age 65 is considered a reasonable default). Your asset allocation will be appropriately allocated to stocks today, but it will adjust over time to become more conservative as you approach retirement.
You make traditional 401(k) contributions with pre-tax money, but you pay taxes when you take the money out. Roth 401(k) contributions are made with after-tax money, but you get a break later. Roughly two-thirds of plans offer a Roth 401(k) feature. Although only 17% of young investors (ages 25–34) invest in a Roth 401(k), they’re more likely than any other age group to take advantage of this feature. Surprised more people don’t invest in a Roth? One reason for low Roth participation is that most plan sponsors offering auto-enrollment put employees in a traditional, tax-deferred account. But for most young investors, directing contributions to a Roth account will get the better grade.
At this point in your career, you’re likely in a much lower tax bracket than you might find yourself in the future, so the value of any tax deduction on today’s traditional tax-deferred account contributions will be far outweighed by the tax-free growth of a Roth account. Also, keep in mind that any company match will be toward the traditional, tax-deferred 401(k) account. By making your deferrals to a Roth, you’re getting immediate tax diversification because you’re holding an account that’s taxed differently.
Start immediately and auto-increase
Ideally, you’ll want to target at least a 12%–15% savings rate for retirement. This target includes any company match. I realize that this may make your eyes roll to the back of your head, but keep reading.
If you’re just starting out, you may be balancing student loan payments with living expenses, and this can seem like an impossible goal. But you can work toward this goal by staying disciplined. With auto-enrollment, for example, your employer may set you up for a 5% deferral, with a 1% automatic annual increase.1
If your plan doesn’t offer auto-features, start with enough to at least capture the company match. Auto-increase your deferral rate by 1%–2% annually, and you’ll get there seamlessly, without feeling the pinch. The key is to make increases automatic, so you don’t have to think about it annually.
If you think waiting a few years won’t make a big difference, you’d be surprised. Below is a simple example comparing 3 investors.
The first investor starts saving 5% of her $40,000 salary at age 25 (and she’s eligible to receive a 3% company match2). Because her salary grows by 1% a year, she increases the amount she saves by 1% each year. She eventually contributes 15% of her salary, including her employer match (by the time she’s 32). Then she maintains that 15% savings rate.
The second investor starts saving at age 30, and the third investor starts saving at age 35 (all other factors are the same). The chart shows the amount of money forfeited by the procrastinating investors who don’t start saving as soon as they can—they also miss out on the 3% company match. As the chart shows, the first investor is at the top of her class from day 1.
Notes: This hypothetical example does not represent the return on any actual investment, and the figures are in today’s dollars (i.e., after inflation). The calculations of the line charts assume a starting salary of $40,000 with a 1% annual growth rate, a 5% annual saving rate with a 1% annual increase plus a 3% company match up to 15%, a 4% annual rate of return, and a 40-year saving horizon. The calculations of the bar charts show the amount of money forfeited if an investor does not defer 3% of her salary to receive the 3% company match beginning at age 25.
Source: Vanguard calculations.
Certainly, the more you can save toward retirement now, the better. But the reality is that investing involves trade-offs, regardless of your stage in life. If you focus on the things you can control—such as picking low-cost, globally diversified investments coupled with a disciplined savings strategy—you’ll find that you can meet your long-term investing goals while balancing short-term needs.
Special thanks to my colleague Jenna McCleary for her contributions to this blog.
1 Participants joining a plan under an automatic enrollment feature have an average deferral rate of 6.1%. Among participants ages 25–34, the average deferral rate is 5.2%. Source: Vanguard, 2017. How America Saves 2017. Valley Forge, Pa.: The Vanguard Group.
2 The most common employer match is $0.50 on the dollar on the first 6% of pay. For purposes of this example, a match of $0.50 on the dollar on the first 6% of pay promises the same matching contribution—3% of pay—as a formula of $1.00 per dollar on the first 3% of pay.